THE PURPOSE OF INSURANCE

We live in a world full of risk. Risk is the possibility of loss. Sometimes the loss is trivial, while other times it causes major personal and financial hardship. There is no way to completely eliminate all risk, but there are ways to avoid, minimize, or protect oneself from risk. When risk is low, or the cost is not too high, one can assume risk. When it is too costly to assume risk, we need other ways to manage it.

Insurance was invented to help merchants minimize financial losses from shipwrecks when moving goods across the ocean in sailing ships. It works on a mathematical principle based on "the law of large numbers," similar to the way odds are calculated in sporting events (statistics).

Shippers noticed that while some merchandise was lost due to shipwrecks, not all ships were lost. If all shippers anted money into a pool to cover the losses of the shippers whose merchandise was lost, then they all had a fair chance of not being wiped out, if disaster befell them. Odds-makers were able to compute the probability of losses to determine how much each shipper needed to pay in order to cover the probable losses, based on the cost of each shipment. Of course, the odds-makers and investors would receive compensation for their services, and they factored that into the premiums, too.

Modern insurance works in the same way. Regardless of the risk, one can determine the mathematical probability of it occurring and the financial risk at stake. Anyone who owns an automobile knows that he or she is required to have automobile insurance to cover the risk of damage to someone else's property. With many years of statistics on automobile damage costs, insurers are able to determine the amount of premium necessary to provide benefits to insure automobile owners. Using the same principles, one can buy insurance to minimize financial loss due to accident, natural disaster, legal liability, illness, disability, and even death.

Over many centuries, the purpose of insurance remains the same: to provide financial relief due to catastrophic losses. Money from many people is pooled to pay for losses incurred by a few.

Insurance is not the only means of managing risk. One way is to avoid risk. Risk avoidance can lower the financial cost of risk. That is why insurance premiums are lower for persons and businesses that take measures to lower risk. For example, automobile insurance premiums are lower for drivers with good driving records (no accidents and no cited violations of driving laws), and non-smokers pay lower medical insurance and life insurance premiums than do smokers. But it is not always possible to avoid risk, and sometimes, insurance premiums may be too costly.

Another way to manage risk is to share it with others. Some insurance policies allow you to share the risk in order to get a lower premium. If you can assume a certain amount of financial risk, then the insurance premium on the balance of the risk will be lower. For example, some automobile policies have lower premiums if you take responsibility for the first $500 of liability--known as a deductible. Medical insurance premiums can be lowered if you have higher co-payments.

Finally, for those who cannot tolerate any financial risk, risk can be transferred to someone else, usually the insurance company, who assumes full responsibility for financial risk. Of course, this method of risk management has the highest premium cost.

Now let's look at some of the different kinds of insurance used in personal financial planning.